On Feedback Effects from Hedging Derivatives |
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Authors: | Eckhard Platen,& Martin Schweizer |
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Affiliation: | School of Mathematical Sciences and School of Finance and Economics, University of Technology, Sydney, Australia,;FB Mathematik, MA 7-4, Technical University, Berlin, Germany |
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Abstract: | This paper proposes a new explanation for the smile and skewness effects in implied volatilities. Starting from a microeconomic equilibrium approach, we develop a diffusion model for stock prices explicitly incorporating the technical demand induced by hedging strategies. This leads to a stochastic volatility endogenously determined by agents' trading behavior. By using numerical methods for stochastic differential equations, we quantitatively substantiate the idea that option price distortions can be induced by feedback effects from hedging strategies. |
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Keywords: | option pricing Black–Scholes formula implied volatility smile skewness stochastic volatility feedback effects |
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